The dividend payout ratio is a metric that helps investors understand how much of a company’s net income it pays out in the form of dividends relative to how much it keeps to reinvest or pay down debt. Here’s a quick look at dividend basics and how investors can calculate the dividend payout ratio themselves.
Understanding Dividends and How They Work
Companies may pay out a portion of their profits to shareholders in the form of a dividend. Investors can take their dividend payments in cash or reinvest them in the market. Not all companies pay dividends, and those that do tend to be large, established companies with predictable profits. If an investor owns a stock or fund that pays dividends, they can expect a regular payment from that company, usually quarterly. Some companies may pay dividends more frequently.
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What is the Dividend Payout Ratio?
The dividend payout ratio expresses the percentage of income that a company pays to shareholders. Ratios vary widely by company. Some may pay out all of their earnings, while others may hang on to a portion to reinvest in the company or pay off debt. Generally speaking, a healthy range for payout ratios is from 35% to 55%. There are certain circumstances in which a lower ratio might make sense for a company. For example, a relatively young company that plans to expand might reinvest a larger portion of its profits into growth.
How to Calculate Dividend Payout
The simplest dividend payout ratio formula divides the total annual dividends by net income, or earnings, from the same period.
The equation looks like this:
Dividend payout ratio = Dividends paid / Net income
For example, if a company reported net income of $120 million and paid out a total of $50 million in dividends, the dividend payout ratio would be $50 million/$120 million, or about 41%. That means that the company retained about 59% of its profits.
An alternative dividend payout ratio calculation uses dividends per share and earnings per share as variables:
Dividend payout ratio = Dividends per share / Earnings per share
A third formula uses retention ratio, which tells us how much of a company’s profits are being retained for reinvestment, rather than paid out in dividends.
Dividend payout ratio = 1 – Retention ratio
Determine the retention ratio with the following formula:
Retention ratio = (Net income – Dividends paid) / Net income
Total dividends paid and a company’s net income are figures you can find in a company’s financial statements, such as its earnings report or annual report.
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Why Does the Dividend Payout Ratio Matter?
Dividend stocks often play an important part in individuals’ investment strategies. Dividends are one of the primary ways stock holdings earn money. (Investors also earn money on stocks by selling holdings that have appreciated in value.) Investors may choose to automatically reinvest the dividends they do earn, increasing the size of their holdings, and therefore, potentially earning even more dividends over time.
The dividend payout ratio can help investors gain insight into the health of dividend stocks. For instance, a higher ratio indicates that a company is paying out more of its profits in dividends, and this may be a sign that it is established, or not necessarily looking to expand in the near future. It may also indicate that a company isn’t investing enough in its own growth.
Lower ratios may mean a company is retaining a higher percentage of its earnings to expand its operations or fund research and development, for example. These stocks may still be a good bet, since these activities may help drive up share price or lead to large dividends in the future.
Paying attention to trends in dividend payout ratios can help you determine a dividend’s sustainability—the likelihood a company will continue to pay dividends of a certain size in the future. For example, a steadily rising dividend payout ratio could indicate that a company is on a stable path, while a sudden jump to a higher payout ratio might be harder for a company to sustain.
It’s worth noting dividend payout ratios that are more than 100% as well. That means the company is paying out more money in dividends than it is earning, something no company can do for very long. While they may ride out a bad year, they may also have to lower their dividends, or suspend them entirely, if this trend continues.
Dividend Payout Ratio vs. Dividend Yield
The dividend yield is the ratio of a stock’s dividend per share to the stock’s current price:
Dividend yield = Annual dividend per share/Current stock price.
For example, if a stock costs $100 and pays an annual dividend of $7 the dividend yield will be $7/$100, or 7%
Like the dividend payout ratio, dividend yield is a metric investors can use when comparing stocks to understand the health of a company. For example, high dividend yields might be a result of a quickly dropping share price, which may indicate that a stock is in trouble. Dividend yield can also help investors understand whether a stock is valued well and whether it will meet the investor’s income needs or fit with their overall investing strategy.
Dividend stocks can be an important component of an investment strategy, creating income or serving as a low-risk way to grow a portfolio. The dividend payout ratio is one measure to help investors evaluate stocks that pay dividends, often providing clues about company health and long-term sustainability.
If you’re interested in adding dividend stocks to your portfolio, you can get started by opening an account on the SoFi Invest® brokerage platform. You can use the platform to build your own portfolio containing stocks and exchange-traded funds.
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